What Happens to Your IRA When You Die?

When an Individual Retirement Account (IRA) owner passes away, specific rules govern the handling of their retirement savings. Understanding these regulations is important for both IRA account holders in estate planning and for those who inherit such accounts, as they dictate how tax-advantaged funds are distributed and taxed after the owner’s death.

Understanding IRA Beneficiaries

Designating beneficiaries for an IRA is a key aspect of estate planning, ensuring assets are distributed according to the owner’s wishes. These designations supersede instructions in a will, highlighting their importance in directing asset transfer. It is advisable to keep beneficiary designations current, especially after significant life events like marriage, divorce, or the birth of a child.

Beneficiaries generally fall into categories such as primary and contingent. A primary beneficiary is the first in line to receive the assets, while a contingent beneficiary serves as an alternate if primary beneficiaries are unable to inherit. When naming individuals, providing full legal names, birth dates, and Social Security numbers can simplify the transfer process. Beyond individuals, beneficiaries can include trusts, estates, or charitable organizations, each with distinct implications for the inheritance process.

The method of distributing assets among multiple beneficiaries upon the death of a primary beneficiary can be specified as either “per stirpes” or “per capita.” A “per stirpes” designation means that if a named beneficiary predeceases the IRA owner, that beneficiary’s share passes to their direct descendants. Conversely, a “per capita” designation distributes the deceased beneficiary’s share equally among the remaining living beneficiaries at that level, rather than passing it down to their descendants. This distinction determines how assets flow through generations, making selection important for aligning with the owner’s intent.

Options for Inherited IRAs

Upon the death of an IRA owner, beneficiaries face various options for handling the inherited account, with choices largely dependent on their relationship to the deceased. Generally, inherited IRA assets must be transferred into a new account titled as an inherited IRA. This new account distinguishes it from the beneficiary’s personal retirement accounts and prohibits additional contributions.

Spousal beneficiaries often have the most flexible options. A surviving spouse can choose to roll over the inherited IRA into their own IRA, treating it as their own account. This allows them to delay distributions until they reach their own required beginning date for Required Minimum Distributions (RMDs), typically age 73. Alternatively, a spouse can remain a beneficiary of the inherited IRA, which offers flexibility in distribution timing, including the option to take distributions based on their life expectancy or using the 10-year rule. If the spouse chooses to treat the IRA as their own, they become subject to their own RMD schedule and can name their own beneficiaries.

For most non-spousal beneficiaries, the SECURE Act introduced the 10-year rule for deaths occurring after 2019. Under this rule, the entire inherited IRA balance must be distributed by the end of the tenth calendar year following the original owner’s death. This applies to most designated beneficiaries, such as adult children or friends. While no annual RMDs are typically required within this 10-year period if the original owner died before their RMDs began, the account must still be fully depleted by the deadline.

However, certain non-spousal beneficiaries qualify as “eligible designated beneficiaries” (EDBs) and are exempt from the standard 10-year rule. EDBs include surviving spouses, minor children of the deceased (until they reach the age of majority, typically 21), disabled or chronically ill individuals, and individuals not more than 10 years younger than the IRA owner. These EDBs can “stretch” distributions over their own life expectancy, offering a longer period for tax-deferred growth. For minor children, the 10-year rule generally commences once they reach age 21, requiring the remaining balance to be distributed within the subsequent 10 years.

When a trust is named as an IRA beneficiary, the distribution rules can become more intricate. A “see-through” trust, which meets specific IRS criteria, can allow the beneficiaries of the trust to be treated as designated beneficiaries for RMD purposes. This enables distributions to be based on the life expectancy of the oldest trust beneficiary, or follow the 10-year rule, depending on the beneficiary type. If the trust does not qualify as a see-through trust, or if the IRA is left to the estate, it is treated as a non-designated beneficiary, leading to potentially shorter distribution periods. If the estate is the beneficiary, the IRA assets may become subject to probate and more restrictive distribution timelines, often requiring full distribution within five years if the owner died before RMDs began, or over the deceased owner’s remaining life expectancy if RMDs had already started.

Taxation of Inherited IRAs

The tax treatment of inherited IRAs depends on the type of IRA and the beneficiary’s relationship to the deceased owner. Distributions from inherited traditional IRAs are generally subject to ordinary income tax for the beneficiary. This means that each withdrawal is added to the beneficiary’s taxable income in the year it is received. The funds in traditional IRAs were contributed on a pre-tax basis, so taxes were deferred until distribution, and this obligation passes to the heir.

Unlike personal IRAs, inherited IRAs are typically exempt from the 10% early withdrawal penalty, even if the beneficiary is under age 59½. However, beneficiaries of inherited Roth IRAs generally receive tax-free distributions, provided the original Roth IRA account had been open for at least five years before the owner’s death. If the five-year holding period was not met, earnings withdrawn from an inherited Roth IRA may be subject to income tax.

Inherited IRAs are included in the deceased’s taxable estate for federal estate tax purposes, but this typically impacts only very large estates exceeding the federal estate tax exemption amount. While the estate may pay estate taxes, beneficiaries generally do not pay estate tax directly on the inherited assets. However, beneficiaries of traditional IRAs may be able to claim an income tax deduction for any federal estate tax paid on the IRA, a concept known as “income in respect of a decedent” (IRD). This means the beneficiary does not receive a step-up in basis on the inherited IRA assets, as they would with other inherited property.

In addition to federal taxes, state income and estate tax rules can vary significantly and may apply to inherited IRA distributions. Some states may impose their own income taxes on these distributions, while others may have estate or inheritance taxes that could affect the transfer of IRA assets. Beneficiaries should consider consulting with a tax professional to understand all applicable federal and state tax implications based on their specific circumstances.

Required Distributions for Inherited IRAs

Beneficiaries of inherited IRAs must adhere to specific rules regarding when and how much they must withdraw from the account, known as Required Minimum Distributions (RMDs). For most non-spousal beneficiaries of IRAs where the owner died after 2019, the primary rule is the 10-year rule. This rule mandates that the entire inherited IRA balance must be distributed by December 31 of the calendar year containing the tenth anniversary of the original owner’s death.

If the original owner died on or after their required beginning date for RMDs, the beneficiary must take annual RMDs in years one through nine of the 10-year period, with the remaining balance distributed by the end of the tenth year. These annual RMDs are calculated based on the beneficiary’s life expectancy.

A beneficiary may also be responsible for taking the original IRA owner’s final RMD for the year of their death if it was not taken before the owner passed away. This distribution must be made by December 31 of the year of death. Failure to take required distributions can result in penalties.